Understanding The S Corp

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As your company gets larger and starts to earn more profits, it is usually a good idea to think about setting up a corporate structure.  And one of the most popular is the S Corp.  After all, you can potentially gain some nice tax benefits.

But of course, the rules can get tricky – and you will have to take on more expenses.

So to make this process easier, there are certain factors to keep in mind.  Here’s a look:

Limited Liability:  This is definitely a big deal, as litigation is ubiquitous.  With an S-Corp, the shareholders are only liable for the amount of their investment in the company.  As a result, this makes it easier to raise capital.

Pass-Through Entity:  The S-Corp itself is actually not subject to taxes.  Rather, the shareholders who receive the profits are taxed.

Example:  Let’s say your company has four shareholders, which each having a 25% interest.  Last year, the profits came to $100,000.  This means that each shareholder will report income of $25,000 on their personal returns.

This can be much better than a C-Corp, which essentially has “double taxation” (the profits are taxed and so are the distributions).  What’s more, depending on the circumstances of a shareholder of an S-Corp, there may be the ability to use losses to offset other income.

Something else:  The profit distributions of an S-Corp are not subject to the self-employment tax (this is for Social Security and Medicare).  In other words, you can save over 15%!  But you need to be careful in how you do this since you are still required to take a reasonable salary.

Red-Tape:  Yes, expect to fill out lots of forms and keep diligent records.  If not, you could lose the advantages of an S-Corp.

Let’s take a look at some of the requirements:

  • You will need to file articles of incorporation with your state as well as have meetings with directors and shareholders.  There will also be a need to keep minutes.
  • An S-Corp can only issue common stock.  By the way, this is why venture capitalists do not invest in this type of entity (keep in mind they want preferred stock, which provides for more protections).
  • Some states do not recognize S-Corps, which means there are no tax breaks (but you still get the benefits with federal taxes).
  • No more than 25% of the revenues of an S-Corp can be for passive activities like interest and investment income.
  • Even though an S-Corp does not pay taxes, there still needs to be a return filed (it is called 1120S).
  • The profits and losses can only be allocated based on the ownership percentages.
  • An S-Corp can only have 100 shareholders.  Also they can only be US citizens, US residents, estates, trusts and certain tax-exempt organizations.
  • There is no deduction allowed for fringe benefits to employees that own more than 2% of the outstanding shares.

Creating an S-Corp:  You will actually take the same steps of putting together a regular corporation (but of course, make sure you meet the requirements discussed above).  Then no later than two months and 15 days after your tax year begins, you will file Form 2553 with the IRS.  You will also need to get the approval of all shareholders.

Estate Planning:  You can use sophisticated techniques for making a gift or setting up a trust, since you can transfer shares of the company.  But of course, this can get complicated and definitely requires the help of a qualified attorney.

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